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SKARBECK: Beware of growing use of 'adjusted' earnings

April 2, 2016

Ken SkarbeckMy last column emphasized that the seven-year bull market in stocks has been driven by rising corporate earnings. Even so, investors shouldn’t cast a blind eye toward how those earnings are being calculated and presented to them.

It seems more and more companies are promoting their earnings in a way that does not adhere to generally accepted accounting procedures, or GAAP. While it is perfectly legal to present non-GAAP earnings alongside GAAP figures, lately the list of items being excluded has expanded to where the difference between the two figures at some companies is substantial. In addition, aggressive companies will promote their non-GAAP earnings to analysts and investors to the point where they imply the adjusted figures represent their true earnings.

Historically, it has been common for companies to show non-GAAP figures that exclude large “one-time, non-recurring” gains or losses that distort the GAAP earnings in a particular quarter. This practice is viewed as a reasonable means to adjust earnings for comparison purposes across other quarterly earnings periods. For example, recently there have been a slew of “one-time” write-downs in the energy sector.

However, if these “one-time” items start showing up in reports again and again, the investor should question whether management is trying to obscure its financial performance. For example, Facebook and Twitter regularly exclude hundreds of millions of dollars of annual stock option expense in their non-GAAP earnings. Last year, Twitter’s GAAP earnings showed a loss of $521 million, but after stripping out stock option expense, Twitter showed a non-GAAP profit of $276 million.

Critics contend that if compensation such as stock options isn’t an expense, what is it? Companies that exclude stock option expense contend there are too many variables that enter into calculating a value for stock options. Yet that argument falls flat since subjective estimates are made in all facets of accounting. Clearly, the companies are suggesting investors ignore these large compensation charges and accept the adjusted figures as actual earnings.

The Wall Street Journal reported that, in 2014, 40 companies that had initial public offerings reported losses under GAAP, but showed profits under their own customized earnings measures.

Items such as executive bonuses, director fees, severance costs, pension expenses and acquisition expenses are more frequently being deducted from GAAP earnings. The Securities and Exchange Commission is aware of the increased divergence showing up between GAAP and non-GAAP earnings and has written letters to 30 companies the past two years criticizing them for over-promoting their adjusted earnings. The obvious concern is that investors are being misled by an inaccurate picture of company financial performance.

The ultimate goal of financial reporting should be to aggregate and present the true economic profits and expenses to the business owners—the shareholders. And there are situations where GAAP accounting might not do the best job in depicting economic reality, like the amortization of certain intangible assets. However, GAAP accounting is supposed to bring a level of uniformity across companies in the way they report their financial results. And the expanded use of customized earnings that exclude recurring expenses from non-GAAP earnings may serve to deceive investors.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. He can be reached at 818-7827 or ken@aldebarancapital.com.

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